Energy & Financial Markets

What Drives Crude Oil Prices?

Spot Prices

Crude oil is traded in a global market. Prices of the many crude oil streams produced globally tend to move closely together, although there are persistent differentials between light-weight, low-sulfur (light-sweet) grades and heavier, higher-sulfur (heavy-sour) crudes that are lower in quality.

Crude oil is processed in refineries to make gasoline, diesel, heating oil, jet fuel, lubricants, petrochemical feedstocks and other petroleum products. While the price of crude oil is often quoted in the media, what usually matters the most to consumers are the prices of the products they purchase. Petroleum product prices tend to move together with crude oil prices, with some variation due to seasonality, factors specific to the market for a particular product, or refining outages.

Crude oil prices are the primary driver of petroleum product prices

Gasoline and crude oil prices tend to move together, with some episodes where gasoline breaks away, typically due to refinery outages or other downstream events.

Both crude oil and petroleum product prices can be affected by events that have the potential to disrupt the flow of oil and products to market, including geopolitical and weather-related developments. These types of events may lead to actual disruptions or create uncertainty about future supply or demand, which can lead to higher volatility in prices. The volatility of oil prices is inherently tied to the low responsiveness or "inelasticity" of both supply and demand to price changes in the short run. Both the stock of oil-using equipment and oil production capacity are relatively fixed in the near-term. It takes years to develop new supply sources or vary production, and it is very hard for consumers to switch to other fuels or increase fuel efficiency in the near term when prices rise. Under such conditions, a large price change can be necessary to re-balance physical supply and demand following a shock to the system.

Much of the world's crude oil is located in regions that have been prone historically to political upheaval, or have had their oil production disrupted due to political events. Several major oil price shocks have occurred at the same time as supply disruptions triggered by political events, most notably the Arab Oil Embargo in 1973-74, the Iranian revolution and Iran-Iraq war in the late 1970s and early 1980s, and Iraq's invasion of Kuwait in 1990. More recently, disruptions to supply (or curbs on potential development of resources) from political events have been seen in Nigeria, Venezuela, Iraq, Iran, and Libya.

Crude oil prices react to a variety of geopolitical and economic events

Oil prices have responded to geopolitical and other events over the past 40 years. Events that disrupt supply or increase uncertainty about future oil supplies tend to drive up prices.

Given the past history of oil supply disruptions emanating from political events, market participants are always assessing the possibility of future disruptions and their potential impacts. In addition to the size and duration of a potential disruption they also consider the ability of other producers and storage withdrawals to offset a potential supply loss. For example, if the market has ample spare production capacity to offset a possible disruption, its likely impact on prices would be smaller than if spare production capacity was much lower. When there are significant concerns about the potential for a disruption at a time when spare capacity and inventories are not seen as sufficient to substantially offset the associated loss in supply, prices may be above the level that might be expected if only current demand and supply were considered, as forward-looking behavior adds a "risk premium."

Weather can also play a significant role in oil supply. Hurricanes in 2005, for example, shut down oil and natural gas production as well as refineries. Petroleum product prices increased sharply as supplies to the market dropped. Severely cold weather in winter can stretch the capability of the market to supply product and push up prices. Other events such as refinery outages or pipeline problems can restrict the flow of oil and products, resulting in higher prices.

However, the influence of these types of factors on oil prices tends to be relatively short lived. Once the problem subsides and oil and product flows return to normal, prices usually return to previous levels.